Case 2 – Capital Investment Decisions

Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal mined is sold under contract, with excess production sold on the spot market.

The coal mining industry, especially high-sulfur coal operations such as Bethesda, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Bethesda Mining does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $5.4 million. Based on a recent appraisal, the company feels it could receive $7.5 million on an aftertax basis if it sold the land today.

Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. The land can then be used for other purposes. As they are currently operating at full capacity, Bethesda will need to purchase additional equipment, which will cost $65 million. The equipment will be depreciated on a seven-year MACRS schedule. The contract only runs for four years. At that time, the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price. However, Bethesda plans to open another strip mine at that time and will use the equipment at the new mine.

The contract calls for the delivery of 500,000 tons of coal per year at a price of $84 per ton. Bethesda Mining feels that coal production will be 750,000 tons, 810,000 tons, 830,000 tons, and 720,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $95 per ton. Variable costs amount to $43 per ton and fixed costs are $5.2 million per year. The mine will require a net working capital investment of 5 percent of sales. The NWC will be built up in the year prior to the sales.

Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in Year 5. The company uses an outside company for reclamation of all the company’s strip mines. It is estimated the cost of reclamation will be $5.4 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area as a condition to receive the necessary mining permits. This will occur in Year 5 and result in a charitable expense deduction of $7.5 million. Bethesda has a 21 percent tax rate and a required return of 12 percent on new strip mine projects. Assume a loss in any year will result in a tax credit.

Assignment Directions

Write a case analysis

You have been approached by the president of the company with a request to analyze the project. Define, calculate, discuss, and use decision criteria to assess the investment using the following methods:

Payback period.
Profitability index
Net present value
Internal rate of return

Based on your analysis, should Bethesda Mining take the contract and open the mine? In your analysis, discuss the advantages and disadvantages of using each method for capital investment decisions. Discuss any other capital investment techniques that you would use to help you make a more informed decision. Are there any other variables that they should consider in their decision?

Struggling with where to start this case analysis? Follow this guide to tackle it step by step!

Step-by-Step Guide to Analyzing the Capital Investment Decision

Step 1: Identify Relevant Cash Flows

Focus only on incremental cash flows related to the project.

Include:

Initial equipment cost ($65M)
Opportunity cost of land ($7.5M)
Net working capital investment (5% of sales)
Annual operating cash flows
Tax effects (depreciation, deductions, salvage)
Reclamation cost and tax shield
Recovery of net working capital

Exclude sunk costs (original land purchase price).

Step 2: Calculate Annual Revenue

Separate contract sales from spot market sales:

Contract: 500,000 tons × $84
Spot market: (Total production − 500,000) × $95

Do this for each of the four years using the given production estimates.

Step 3: Estimate Operating Costs

Variable costs: Total tons × $43
Fixed costs: $5.2 million annually

Subtract costs from revenues to obtain EBIT.

Step 4: Incorporate Depreciation and Taxes

Use the 7-year MACRS schedule for depreciation.
Compute taxes using the 21% tax rate.
Remember: depreciation is a non-cash expense but provides a tax shield.

Step 5: Calculate Operating Cash Flow (OCF)

Use the standard formula:

OCF = EBIT × (1 − Tax Rate) + Depreciation

Do this for Years 1–4.

Step 6: Account for Terminal Year Cash Flows

In Year 5 include:

Reclamation cost (after-tax)
Charitable donation tax benefit
Recovery of net working capital

Do not include salvage value if equipment is reused.

Step 7: Apply Capital Budgeting Techniques

1. Payback Period

Measures how long it takes to recover the initial investment.
Advantage: Simple and intuitive
Disadvantage: Ignores time value of money and cash flows after payback

2. Net Present Value (NPV)

Discount all cash flows at 12%.
Decision rule: Accept if NPV > 0
Advantage: Best measure of value creation
Disadvantage: Sensitive to assumptions

3. Internal Rate of Return (IRR)

Discount rate where NPV = 0.
Decision rule: Accept if IRR > 12%
Advantage: Easy to interpret
Disadvantage: Can be misleading with unconventional cash flows

4. Profitability Index (PI)

Present value of future cash flows ÷ initial investment
Decision rule: Accept if PI > 1
Useful when capital is rationed.

Step 8: Make the Decision

Based on your results:

Compare all four methods
Identify which metrics support or oppose the project
Place greatest weight on NPV, supported by IRR and PI

State clearly whether Bethesda should accept the contract and open the mine.

Step 9: Discuss Additional Considerations

Address qualitative and strategic factors:

Environmental regulation risk
Coal price volatility
Long-term demand for high-sulfur coal
Reputational impact of land donation
Future reuse of equipment

You may also mention sensitivity analysis or scenario analysis as additional tools.

Step 10: Conclude Professionally

Summarize:

Key financial findings
Strengths and weaknesses of each method
Final recommendation supported by quantitative and qualitative analysis

Capital Investment Analysis for a New Strip Mining Project